What Is a Crypto Flash Loan? How To Prevent Flash Loan Attacks

You can't use it to buy a car or a house, so what's the point of a crypto flash loan?

To get a loan in a traditional bank, you must provide documents and go through validation and eligibility processes. However, this process is unnecessary for a crypto flash loan. The whole process happens instantaneously, allowing users to access and return such loans almost immediately.

Flash loans are innovative in the crypto space. They are very useful but can also be manipulated by attackers. Continue reading to find out how these flash loans work and how you can protect yourself from attacks.

What Is a Crypto Flash Loan?

Flash loans are uncollateralized loans that have gained popularity in the crypto space. They are unsecured loans that some DeFi platforms make available to investors. These loans are considered unsecured because they do not require you to have any collateral before accessing them.

To access a flash loan, a smart contract is built on the blockchain that requests to borrow money. Carrying this out might require some developer knowledge and coding skills. However, some tools allow users to access flash loans without coding knowledge, such as Collateral Swap and DeFi Saver.

3 Key Flash Loan Features

Flash loans have the following peculiar properties.

1. Unsecured Loans

This means that you don't need to secure it with any form of collateral, deposit, or assets to get it. There is also no need for a credit check.

2. Smart Contracts

Smart contracts ensure that all the processes are done within one transaction. For example, the lending process will be reversed if you do not return the funds within a transaction. This process also keeps the loan safe and reduces the risk for lenders.

3. Instant Transactions

We are used to a borrowing system where we borrow money, use it for a while, and then return it during a defined period. This is not the same as flash loans. Once you get a flash loan, you must execute almost immediate transactions using smart contracts and return the money before the single block transaction ends. The whole process typically happens in a flash.

3 Uses of Crypto Flash Loans

You're probably wondering what you need a flash loan for since you cannot hold it for long and can't use it to buy a house or other physical assets. In short, that's not what it is meant for.

What, then, are flash loans used for?

1. Arbitrage Trading

One of the major reasons traders take flash loans is to make money off the little price differences that occur on different exchanges. Arbitrage trading works by using a huge amount of traders' funds to make money, and getting a crypto flash loan is a way of securing easy funding for such moves.

To do this, you take a flash loan and then use it to buy an asset on an exchange where it is cheaper. You then sell it on an exchange where it is costlier. After this process, you pay back the flash loan with fees and interest. It's a three-stage process: get the loan, use the loan, and return the loan—all in one transaction.

2. Collateral Swapping

In this case, the collateral used in securing the user's loan is used to replace another type of collateral.

3. To Save Transaction Fees

Flash loans sometimes combine several transactions into a single one, reducing transaction fees. The transaction cost is usually deducted from the loan amount, so the parties involved enjoy lower fees.

What Is a Crypto Flash Loan Attack?

The opportunity to get loans without collateral has led to the rise of many flash loan attacks. A flash loan attack occurs when an attacker takes out large flash loans and uses the fund to manipulate market prices and exploit DeFi protocols. Such malicious agents usually profit significantly from such moves, which is at the expense of regular investors.

Flash loan attacks can also be carried out by exploiting the vulnerabilities of a platform. Attackers are usually very fast with the process because they know they must pay the debt back within a single transaction. As was mentioned earlier, an unpaid flash loan gets reversed like nothing ever happened. Flash loan attackers try to devise new ways to manipulate the market while not going against blockchain protocols.

Flash loan attacks are common in DeFi because they are low-risk and high-reward. They are affordable as all you need to carry them out is your computer and an internet connection. There is usually no trace after the act has been done, making it hard to trace flash loan attackers. Also, loans are used in carrying out all the actions, so it doesn't require much capital to be carried out successfully.

Reducing Flash Loan Attack Risks

The following are some precautions you can take to reduce the risk of being a victim of a flash loan scam:

Decentralized Pricing Oracles

Using decentralized pricing oracles can help curb the price manipulation caused by flash loan attacks. These decentralized oracles, like Chainlink and Band Protocol, use different sources to determine the accurate prices of different cryptocurrencies.

The pricing oracle will make price manipulation by attackers fail, and the entire process will reverse as the transaction time elapses.

High-Frequency Price Updates

Here, liquidity pools consult the decentralized oracles for pricing more often. With this, the token's price is updated, which will invalidate price manipulations.

Flash Loan Attack Detection Tools

Some platforms tackle the flash loan security challenge. An example of such a platform is OpenZeppelin. The platform launched OpenZeppelin Defender, which helps detect smart contract attacks and unusual activities, helping developers neutralize attacks.

Only Take a Crypto Flash Loan If You Understand the Risks

Even with all the solutions that have been suggested, you need to remember that DeFi technology isn't developed enough for you to be complacent since hackers often find new vulnerabilities.

Developers can only get by for now by making the most of the solutions they have now. If those solutions don't work, they will learn something new every time they are attacked. There is also the hope that as smart contracts get stronger and more systems use security tools and decentralized oracles for pricing, we'll see fewer attacks from hackers.